PANOECONOMICUS, 2015, Vol. 62, Issue 2 (Special Issue), pp. 237-256 UDC 339.743:330.

357 (100-773)
Received: 16 September 2014; Accepted: 09 January 2015. DOI: 10.2298/PAN1502237O
Original scientific paper

Jos Luis Oreiro Capital Accumulation, Structural

Change and Real Exchange Rate
Institute of Economics,
Federal University of Rio de Janeiro;
Researcher level I at National Scientific
Council and Technological
Development (CNPq);
President of Brazilian Keynesian
in a Keynesian-Structuralist
Association,
Brazil Growth Model
jose.oreiro@ie.ufrj.br

Fabricio Missio
Summary: The aim of this paper is to show at theoretical level that maintaining
Department of Economics,
State University of Mato Grosso do Sul a competitive real exchange rate positively affects the economic growth of
(UEMS), developing countries by means of a Keynesian-Structuralist model that com-
Brazil
fabriciomissio@gmail.com
bines elements of Kaleckian growth models with the balance of payments
constrained growth models pioneered developed by Thirlwall. In this setting,
Frederico G. Jayme the level of real exchange rate is capable, due to its effect over capital accumu-
Jr. lation, to induce a structural change in the economy, making endogenous in-
Center for Development and Regional
come elasticities of exports and imports. For reasonable parameter values it is
Planning (Cedeplar), shown that in steady-state growth there is two long-run equilibrium values for
Federal University of Minas Gerais
(UFMG),
real exchange rate, one that corresponds to an under-valued currency and
Brazil another that corresponds to an over-valued currency. If monetary authorities
gonzaga@cedeplar.ufmg.br run exchange rate policy in order to target a competitive level for real exchange
rate, than under-valued equilibrium is stable and the economy will show a high
Acknowledgments: Paper delivered at
11th International Conference: growth rate in the long-run.
Developments in Economic Theory and
Policy, held at Department of Applied
Economics V, University of Basque Key words: Exchange rate, Economic growth, Structural change.
Country, Bilbao, from 26th to 27th of
June, 2014. The comments of two
anonymous referees of JEL: 011, O40, O41.
Panoeconomicus are gratefully
acknowledged. Financial support of
National Scientific Council (CNPq) is
also gratefully acknowledged.

The objective of this article is to contribute to the theoretical analysis of the relation-
ship between the level of real exchange rate and long-term growth in developing
economies by means of a growth model that combines elements from both the Key-
nesian/Kaleckian and the Latin American Structuralist approaches. The main hypo-
thesis that underlies the construction of our growth model is that maintaining a com-
petitive real exchange rate induces investment and structural change in the economy,
at the same time that allows relaxing the external constraint to long term growth giv-
en by balance of payments equilibrium condition. This means that exchange rate pol-
icy can influence growth not only through an increase of short-term competitiveness,
but also by providing the necessary incentives for investment and technological de-
velopment. This implies that exchange rate policy is capable of influencing the long-
term supply-side conditions, as it is capable of inducing a change in income elastici-
ties of exports and imports.
238 Jos Luis Oreiro, Fabricio Missio and Frederico G. Jayme Jr.

The article is organized in six sections. In Section 1 we will present a brief re-
view of empirical and theoretical (heterodox) literature about the relationship be-
tween the level of real exchange rate and economic growth. In Section 2 we will de-
velop a model of capital accumulation and income distribution in order to analyse the
effects of changes in the level of real exchange rate over the pace of capital accumu-
lation. In Section 3 we make a brief review of the literature that explores the nexus
between structural change, capital accumulation and real exchange rate. In Section 4
we present a balance of payments constrained growth model with endogenous in-
come elasticities of exports and imports. Section 5 combines the models developed in
Sections 2 and 4 in a single Keynesian-Structuralist growth model in order to analyse
the effects of different exchange rate policies over the pace of capital accumulation
and economic growth. Section 6 made a brief review of the results obtained through
out the paper.

1. Real Exchange Rate and Economic Growth: A Review of the

Literature
We have recently been seeing the growth of an important literature on the relation-
ship between the real exchange rate and growth. Ofair Razin and Susan M. Collins
(1999) indicated that there are important nonlinearities in the relationship between
exchange rate misalignments - defined as long-lasting deviations of the real exchange
rate from an underlying reference value, given by fundamentals - and the real
growth of output. Their study employed a sample of 93 developed and developing
countries, for the 1975-1993 period. The empirical results show that very high over-
valuations are associated to lower growth in the long-term, whereas, on the other
hand, moderate under-valuations positively impact GPD growth. Dani Rodrik (2008)
based in a panel of 188 developed and developing countries from 1950 to 2004
showed that real exchange rate undervaluation had positive and statistically signifi-
cant effects over growth rate of per capita income of these countries, even after con-
trolling for variables as domestic saving rate, terms of trade and government con-
sumption as a percent of GDP. He also shows that the effect of undervaluation is
strongest for developing than developed countries. Paulo Gala (2008) finds a nega-
tive relationship between growth of GDP per capita and a PPP-based index of real
exchange rate overvaluation in a panel of 58 developing countries for the period
1960-1999. His findings were robust to changes in control variables and econometric
techniques. Martn Rapetti, Peter Skott, and Arslan Razmi (2012) showed that Ro-
driks findings are sensitive to the criterion used do divide the sample between de-
veloped and developing countries. Based on alternative classification criteria and
empirical strategies to evaluate the existence of asymmetries between groups of
countries, they find that the effect of exchange rate undervaluation on growth is in-
deed larger and more robust for developing countries than were found in Rodriks
paper. Sophie Breau, Antonia Lpez Villavicencio, and Valrie Mignon (2012)
showed, through a Panel Smooth Transition Regression Model, that real exchange
rate misalignments have differentiated impact on economic growth depending on
their sign: whereas overvaluation negatively affect economic growth, real exchange

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 Capital Accumulation, Structural Change and Real Exchange Rate in a Keynesian-Structuralist Growth Model 239

rate undervaluation significantly increases it. Regarding the Brazilian case, Jos Luis
Oreiro, Lionello F. Punzo, and Eliane Araujo (2012) found that exchange rate misa-
lignments had a negative and statistically significant effect on the growth rate of real
output for the 1994-2007 period.
The relationship between the real exchange rate and growth is, however, being
neglected in the post-Keynesian growth literature. In the so-called balance of pay-
ments-constrained growth models, which Anthony P. Thirlwall (1979) pioneered, the
long-term equilibrium growth rate depends on the ratio between the income elastici-
ties of exports and imports. In these type of models that are no mechanism by which
the level of real exchange rate can affect long-term growth; only the rate of change
of real exchange rate can do it. But these is also considered irrelevant to long-term
growth either because empirical work had shown that price elasticities of exports and
imports are low, hence a positive rate of change of real exchange rate (a cumulative
real exchange rate depreciation) would have nothing but a reduced impact on the
growth rate of exports and imports; or terms of trade and real exchange rate do not
display an upward or downward trend in the long-term, which means that long term
growth rate of exports and imports do not depend on the rate of change of the real
exchange rate but only on growth rate of foreign and domestic output (John S. L.
McCombie and Mark Roberts 2002, p. 92).
Regarding the so-called neo-Kaleckian models of growth and income distribu-
tion, the level, instead the rate of change, of the real exchange rate can affect long-
term growth, since the level of real exchange rate had a direct impact over income
distribution. If a profit-led regime of accumulation prevails, than a real exchange rate
devaluation will result in an increase of capacity utilisation and investment rate. This
is due to the fact that devaluation of real exchange rate will reduce real wages and
increases profit margin of firms, inducing an increase in their planned investment
(Amit Bhaduri and Stephen Marglin 1990; Robert A. Blecker 2002). Lower wages
will, for sure, reduce consumption demand, since workers propensity to consume is
assumed to be higher than capitalists propensity to consume; but, if the difference
between both propensities is small and investment is highly sensible to changes in
the profit margin, then the fall in consumption demand due to lower wages will be
more than offset by increased investment demand. This leads to an increase of capac-
ity utilisation. Otherwise, lower real wages due to exchange rate devaluation will
decrease capacity utilisation and investment demand. In this case, the economy can
be said to operate in a wage-led regime.
Another way the real exchange rate can influence long-term growth, which is
particularly important for developing economies, is through its impact on the degree
of structural heterogeneity of these economies. Structural heterogeneity, as defined
by Latin American Structuralist School of Thought, is a situation where an economy
had only a small dynamic core of economic activities, restricted to relatively modern
primary exports sector with a few associated manufacturing and service segments.
The rest of the economy is characterized by a primitive occupational structure and
high unemployment rate. These economies are at the same time specialised and hete-
rogeneous. This is because structural heterogeneity refers to the technological and
productivity differences inside the productive structure, which are largely the result

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240 Jos Luis Oreiro, Fabricio Missio and Frederico G. Jayme Jr.

of dynamic insufficiency of the system, caused by the slow pace of capital accumula-
tion, by the adoption of inadequate technologies and by the wide variation of the
quality of the workforce (see Octavio Rodriguez 2009).
It should be highlighted that, in this setting, the level of real exchange rate in-
fluences both capital accumulation and technological innovation, thereby establish-
ing a connection between real exchange rate and growth from the supply-side of the
economy. In fact, technology is the keystone of long-term growth, as improved pro-
duction techniques lead to higher productivity and faster growth rates, which in turn
allow for incorporating surplus labour and reducing structural heterogeneity. Struc-
tural change is, however, the effect of capital accumulation itself, since the latter re-
duces the technological gap (for the concept of technological gap, see Jan Fagerberg
1994) - given that, as a rule, new technologies are embodied in new machinery and
equipment (Nickolas Kaldor 1957). The level of real exchange rate can induce tech-
nological and structural change by means of a higher investment rate. Since an in-
crease in the level of real exchange rate - i.e. a real exchange rate depreciation - will
induce an increase in the profit share, then it will increase internal funds and the self-
financing capacity of firms, producing a reduction in borrowers and lenders risk and,
thereby, stimulating a higher rate of capital accumulation.

2. A Model of Capital Accumulation, Income Distribution and

Real Exchange Rate
We will consider a small developing economy that produces a single homogeneous
good [X], used for both consumption and investment. The inputs are labour [N] and
an imported raw material [M]. Firms in this economy are price-makers in goods mar-
ket, fixing the price for a unit of homogeneous output by means of a mark-up over
direct unitary costs of production. The price setting rule is show in Equation (1):
].
= (1 + )[ + (1)

Where: p is the price of the domestic good, z is the mark-up rate, w is the
nominal wage rate, e is the nominal exchange rate, p* is the price of the imported
raw materials in foreign currency, = is the unitary labour requirement and
= is the unitary requirement of raw material.
Let us define Y as the gross value of output in real terms and pY as the gross
value of output in nominal terms. So we have the accounting identity given below:

= . (2)

This means that pX is the net added value in nominal terms, and X is also the
net added value in real terms.

Let us define = as the real wage rate and = as the level of real ex-
change rate. The profit share is given by:

= = =1 . (3)

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 Capital Accumulation, Structural Change and Real Exchange Rate in a Keynesian-Structuralist Growth Model 241

Dividing both sides of Equation (1) by p, we get:

1 = (1 + )[(1 ) + ]. (4)

Solving Equation (4) for h, we get:

= + . (5)

In Equation (5) we see that a devaluation of real exchange rate will increase
profit share for a given mark-up rate.
Like Michael Kalecki (1971), Kaldor (1955-56) and Luigi L. Pasinetti (1962)
we will suppose the existence of two social classes, workers and capitalists. Workers
supply labour and receive wages as income which is fully spent in consumption. Ca-
pitalists earn only profits and save a constant share of them. Aggregate real savings
[S] are thus defined as a fixed portion s of capitalist profits [P], as shown in Equa-
tion (6).

= = . (6)

Where: is the level of real output that is compatible with full capacity utili-
zation and K is the capital stock of the economy.

Defining = as the level of capacity utilization, = as the profit share
and = as the productivity of capital, we get:

= = . (7)

In Equation (7) is aggregate saving as a ratio of capital stock. Without loss

of generality we can set q = 1, so we get:
= = . (7a)

As we can see in Equation (7a) since the aggregate saving rate is a positive
function of the profit share, a devaluation of real exchange rate will induce an in-
crease in the saving rate of the economy as a whole. This occurs because the propen-
sity to save out of profits is higher than the propensity to save out of wages, so a in-
come redistribution from wages to profits - due to the exchange rate devaluation -
will cause a reduction in aggregate consumption and, hence, an increase in the saving
rate.
Regarding investment behaviour, we will suppose that the growth rate of capi-
tal stock that is desired by capitalists is given by:
= + + + . (8)

Where: is the desired growth rate of capital stock, represents autonom-

ous part of investment, determined by animal spirits.
The specification of investment equation follows Bhaduri and Marglin (1990)
on taking the desired rate of capital stock as a separable function of profit share and
capacity utilization; contrary to the standard procedure used in Kaleckian growth

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242 Jos Luis Oreiro, Fabricio Missio and Frederico G. Jayme Jr.

models of taking growth rate of capital as a function of the rate of profit (Robert
Rowthorn 1981; Amitava K. Dutt 1984, 1990).
Our innovation here consists in introducing the level of the real exchange rate
as an independent argument of the investment function. Furthermore we also suppose
that the square of real exchange rate, not only its level, affects investment behaviour.
This means that growth rate of capital stock is a non-linear function of the level of
real exchange rate. The non-linearity is based on the idea that, on one hand, currency
devaluations positively affect the competitiveness and profitability of tradable sec-
tors, thus stimulating firms that produce exportable goods to invest in capacity ex-
pansion and in the acquisition of new production techniques. The argument here is
that technological progress should be considered, to a great extent, endogenous to
variations of the level of the real exchange rate. The technological gap can be re-
duced by acquiring foreign technology or by developing new processes and innova-
tions internal to the firm, in both cases levered by the greater availability of funds
(profitability). Nevertheless, we also consider that technological progress can also
occur through capital accumulation, for new technologies are, as a rule, embodied in
new machinery and equipment. On the other hand, currency devaluation also in-
creases the costs of imported inputs, including machinery and equipment, thereby
increasing the cost of investment and reducing the desired growth rate of capital
stock. There is no reason to believe that these opposite effects cancel each other. It is
more reasonable to think that for very low levels of real exchange rate, the competi-
tiveness and profitability of tradable sectors are also very low, discouraging invest-
ment in new machines and equipment, as a result the growth rate of capital stock is
also be low. For very high levels of real exchange rate, however, the cost of invest-
ment will be very high due to high prices of imported machines and equipment. As a
result, the growth rate of capital stock will again be low. In this case, for intermediate
levels of real exchange rate competiveness, profitability and the cost of investment
will be at reasonable levels in order to induce a high rate of capital accumulation. In
order to formalize this non-linear effect of real exchange rate over capital accumula-
tion, the growth rate of capital stock is supposed to be a square function of real ex-
change rate.
Gilberto Tadeu Lima and Gabriel Porcile (2013) had also developed a dynam-
ic model of growth and capacity utilisation that takes into account the joint determi-
nation of international competitiveness (measured by the real exchange rate) and the
functional distribution of income. As regards our current model, this means that the
accumulation function (the investment function) should not be specified with h and
as independent terms. In what follows we will consider the case where 2 0 , that
is we will exclude profit share from the accumulation equation.
Following Oreiro and Araujo (2013), we will suppose that net exports as a ra-
tio of capital stock [ ] are given by:
= + . (9)

Where: , , > 0.
In Equation (9) we are assuming that the Marshall-Lerner condition holds such
that a devaluation of the real exchange rate an increase in net exports.

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 Capital Accumulation, Structural Change and Real Exchange Rate in a Keynesian-Structuralist Growth Model 243

Regarding inflation, we will consider that the rate of change of domestic pric-
es is equal to the rate of change of nominal wages minus the rate of change of labor
productivity:
= . (10)

Where: is the rate of inflation, is the nominal wage inflation and is the
growth rate of labor productivity.
Following Dutt (1994) we will suppose that over time the money wage

changes according to the gap between the wage share targeted by workers, , and
the actual wage share and the expected rate of inflation. Since ( = 1 ), we can
write the following Equation for the rate of change of nominal wages:
= ( ) + . (11)

Where: > 0 and < 1.

Substituting (11) in (10) and assuming perfect foresight ( = ) as Dutt
(1994) we get:

= ( ) . (12)

In Equation (12) we can see that the equilibrium rate of inflation is a function
of the gap between the actual level of profit share and the profit share that is targeted
by workers. Since profit share is a positive function of the level of real exchange rate,
we can conclude that a devaluation of real exchange rate is followed by a permanent
increase in the rate of inflation. This result is due to real wage resistance, that is, the
attempt of workers to preserve their real wages (and wage share in income) by means
of bid up money wages as a reaction to offset the effect of currency devaluation over
real wages (Mark Setterfield 1997, p. 62). The real wage resistance will be higher
(and the increase in the rate of inflation) as higher is the magnitude of the coefficient
.
Considering an open economy without government activities, the short-run
equilibrium condition is given by the equality between planned savings and invest-
ment, that is:
+=. (13)

After substituting (7a), (8) and (9) in (13) we get the short-run equilibrium
value for capacity utilization, considering the simplest case where 2 0 :
( )
= . (14)

In order for the short-run equilibrium to be stable is necessary to assume

that: > 0, that is propensity to save out of profits must be higher than
propensity to invest out of profits (Skott 2010, p. 110).
Equation (10) represents short-term equilibrium value of capacity utilisation,
indicating the level of capacity utilization that makes planned investment equal to the

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244 Jos Luis Oreiro, Fabricio Missio and Frederico G. Jayme Jr.

savings of capitalists. In other words, it is the IS curve for an equilibrium trade bal-
ance without the government.
In Equation (5) we can define = and = . So we get:

= + . (5a)

After substituting (5a) in (14), we get:

( )
= . (15)
( )

In order to get the short-run equilibrium value for the growth rate of capital
stock is necessary to put (15) in (8). Then we get:
+ +
= . (16)

Where: = + > 0; = ( + ( + ) ) > 0;
= ( + ) =?; = > 0; = ( + ) > 0.
In order to analyse the relation between the short-run equilibrium value of the
growth rate of capital stock and the level of real exchange rate let us do a numerical
simulation of the model, imposing the following value for the parametars of the
model (Table 1).

Table 1 Values Used in the Numerical Simulation

Parameter Value
0.7
0.01
0.4
0.01
0.075
0.005
0.02
0.01
0.005
0.075
Source: Authors own elaboration.

One important remark about the values presented above. The relatively high
value for the propensity to save out of profits is based on the estimates of Kaldor
(1966, p. 312).
For these numerical values, the relationship between the growth rate of capital
stock and the level of real exchange rate if given by a hump shaped curve as we can
see in Figure 1 below.
In Figure 1 we can see that there is a level of real exchange rate that maximiz-
es the growth rate of capital stock. Let this optimal level of real exchange rate. If
real exchange rate is over-valued, that is if is below , then the growth rate of capi-
tal stock can be increased by means of a devaluation of real exchange rate. On the

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 Capital Accumulation, Structural Change and Real Exchange Rate in a Keynesian-Structuralist Growth Model 245

other hand, if real exchange rate is under-valued, that is if it is above , than the rate
of capital accumulation can be increased by means of an appreciation of real ex-
change rate.

0.05
0.045
0.04
0.035
0.03
0.025
0.02
0.015
0.01
0.005
0
0.1 0.3 0.5 0.7 0.9 1.1 1.3 1.5 1.7 1.9 2.1 2.3 2.5

Growth rate of capital stock

Source: Authors own elaboration.

Figure 1 Growth Rate of Capital Stock as a Function of Real Exchange Rate

3. Productive Heterogeneity, Balance of Payments Constraint

and Structural Change
We admit throughout this article that a devaluation of real exchange rate affects the
economys productive heterogeneity and, consequently, the income elasticities of
exports and imports. The hypothesis that both elasticities are endogenous has been
recently taken up in the literature (Thomas I. Palley 2002; Nelson H. Barbosa-Filho
2006; Alberto Botta 2009; Ricardo A. Araujo 2012; Marcos A. R. Ferrari, Fbio N.
P. Freitas, and Barbosa-Filho 2013; Luiz Carlos Bresser-Pereira, Oreiro, and Nelson
Marconi 2014). We consider, nevertheless, that they are endogenous to the level of
the real exchange rate, a hypothesis that Fabricio Missio and Frederico G. Jayme Jr.
(2012) and Bresser-Pereira, Oreiro, and Marconi (2015) had developed.
According to Bresser-Pereira, Oreiro, and Marconi (2014, 2015) a devaluation
of real exchange rate affects the productive heterogeneity of the economy as it reduc-
es the relative real wages and the unit labour costs. This will change the level of in-
ternational specialization, increasing the number of goods that are manufactured in
the country and, consequently, the share of manufacturing industry in GDP. As a
consequence of that income elasticity of exports will increase and income elasticity
of imports will decrease, thereby increasing the growth rate of real output that is
compatible with the balance of payments equilibrium.
Missio and Jayme Jr. (2012) admit that the income elasticity of the demand for
exports is a direct function of, amongst others, the number of goods produced by a
country and the level of technology embodied in them. In line with the preceding

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246 Jos Luis Oreiro, Fabricio Missio and Frederico G. Jayme Jr.

work, they consider that variations of the real exchange rate affect real wages, which
leads to a diversification or specialisation of the economy. This means that when real
wages rise, for example, the sectors already in a disadvantaged position in the inter-
national market, given the low technological content of their goods, lose certain mar-
kets or cease to exist altogether. This forces the economy to specialise in sectors with
natural comparative advantages. For developing economies, this means specialising
in natural primary goods. Since income elasticity of the demand for exports of these
goods is low; then specialising in natural primary goods will heightens the balance of
payments constraint to growth. On the other hand, reducing real wages (a devaluation
of real exchange rate) leads to a productive diversification, which in the long-term
implies greater export capacity and lower dependency on imports.
The authors also highlight the fact that maintaining a competitive real ex-
change rate may strongly induce technological progress. More specifically, they ar-
gue that a devaluation of real exchange rate, as it increases the profits and self-
financing capacity of firms, increases the funds available for investment projects re-
lated to research and development. In other terms, the argument goes that an overva-
lued currency is associated to a (temporary) redistribution of income in favour of
wages, which implies that firms will have lower self-financing capacity. This, in turn,
reduces their funds for acquiring new technologies and their access to external
finance, since information asymmetries in financial markets generate credit rationing.
Thus, even in face of the possibility of acquiring inexpensive technology abroad, it is
likely that various sectors will be unable to invest in modernising their productive
structures, in light of the lack of self-financing capacity and credit rationing. On that
account, it is with a competitive currency that one expects firms to undergo innova-
tive activities leading to greater productive heterogeneity (a greater scope of pro-
duced goods, for example) and also to structural homogenisation, for technological
progress is then incorporated in sectors dissociated from the world market. Since the
return of innovative activities is higher in more backwards sectors, the discontinuities
are expected to be rapidly overcome.
They also defend that structural change can be brought about by capital accu-
mulation itself. The latter reduces the technological gap, since new technologies are,
as a rule, embodied in new machinery and equipment. Capital accumulation in turn
critically depends on macroeconomic policies, especially an exchange rate policy
focused on preserving the competitiveness of domestic industries. To demonstrate
this argument the authors developed a model with endogenous elasticities of the de-
mand for exports and imports, which depend on the average age of the economys
capital stock. It is assumed that the newer or more modern is the capital stock the
greater will be the technological content of the goods produced and, therefore, the
higher will be the income elasticity for the demand for exports and the lower will be
the income elasticity of the demand for imports. This means that a capital accumula-
tion effort, with an impact on the productive structure via the modernisation of its
manufacturing base, will increase the technological content of exports and, hence,
will also raise the income elasticity of the demand for exports and the growth rate
compatible with balance of payments equilibrium.

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 Capital Accumulation, Structural Change and Real Exchange Rate in a Keynesian-Structuralist Growth Model 247

Lastly, it should be noted that increasing the presence of tradable sectors as a

consequence of maintaining a competitive real exchange rate will increase the effects
of dynamic economies of scale associated with the so-called Kaldor-Verdoorn Law.
According to this law, there is a positive relationship between the growth of manu-
facturing output and the growth rate of productivity in manufacturing, with causality
running from the former to the latter. In short, this happens because when output
grows it brings about, through time, relevant transformations in the productive struc-
ture and in the composition of demand. This benefits manufacturing, for such trans-
formations lead to using new production processes or developing new goods. Moreo-
ver, new firms appear and/or the existing ones grow, which enables them to use more
modern equipment, possibly better suited to larger productive units.
The main point of this approach is that a demand-induced increase of output
leads to productivity gains in sectors that display, in macroeconomic terms, dynamic
economies of scale. We highlight that these economies of scale are associated to
technological changes, and they are not, therefore, reversible. They mostly arise due
to learning by doing and to the growing division of labour market growth brings
about. It is thus the case that maintaining a competitive real exchange rate, insofar as
it raises foreign demand, leads to a faster growth of output and productivity. This
revisits the idea that there is a cumulative causation based on the mutual feedback
between growth and increasing returns, associated to the greater technological
progress the expansion of output induces. The growth of manufacturing sectors that
maintaining a competitive exchange rate brings about would stimulate productivity
gains and contribute to accelerate the rate of technological change of all the econo-
my, increasing its competitiveness in the foreign market. Additionally, the increase
of productive heterogeneity in a dual economy la Lewis allows for increasing
labour productivity by relocating workers from non-tradable, backwards sectors to
advanced, tradable sectors.
Therefore, to sum up, we argue that maintaining a competitive real exchange
rate increases productive heterogeneity, technological progress, self-financing capac-
ity of investment and labour productivity. In the long-term, this leads to a higher in-
come elasticity of the demand for exports. An analogous argument can be made for
the income elasticity of the demand for imports, which is an inverse function of the
number of goods the country produces and of the technology they embody. Conse-
quently, a devaluation of real exchange rate, as it increases the productive hetero-
geneity and the technological content embodied in the goods, reduces the necessity
of importing foreign goods, decreasing the income elasticity of the demand for im-
ports.

4. A Balance of Payments Constrained Growth Model with

Endogenous Elasticities
Following the literature on balance of payments-constrained growth (see Thirlwall
2002, Chapters 4-5), the demand for exports and imports are given by the following
equations:

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248 Jos Luis Oreiro, Fabricio Missio and Frederico G. Jayme Jr.

= , (17)

,
= , (18)
,

where: is the price of domestic output, is the quantum of exports, is the price
of foreign output, is the nominal exchange rate, is the quantum of imports, is
domestic real output, is the foreign real output, ( 0) is the price elasticity of
the demand for imports, is the income elasticity of the demand for imports,
( 0) is the price elasticity of the demand for exports and is the income elasticity
of the demand for exports.
Assuming zero capital mobility, current account equilibrium is given by:
= . (19)

Taking the rate of change of Equations (13), (14) and (15) we get:
= + , , (20)

= + + , (21)

+ = + + . (22)

Where: is the rate of growth of exports, is the growth rate of imports,

,is the growth rate of the rest of the world, is the growth rate of domestic out-
put, is the rate of change of nominal exchange rate, is the rate of change of do-
mestic price and is the rate of change of foreign price.
Assuming that relative prices measured in a common currency remains un-
changed in the long-run (Thirlwall 2002, p. 71) than we can set: + = 0.
Putting (20) and (21) in (22) we get:
= , . (23)

Equation (23) states that the growth rate of real output that is compatible with
balance of payments equilibrium in the long-run is given by the ratio of income elas-
ticity of exports and income elasticity of imports multiplied by the growth rate of the
rest of the world. This is the so-called Thirlwalls law.
The difference with Thirlwalls original work is that we will consider, based
on the discussion made in last section, the case where income elasticities exports and
imports are endogenous to the level of the real exchange rate as in Equations (24)
and (25) bellow:

= ( ); > 0, (24)

= ( ); < 0. (25)

Substituting (24) and (25) in (23) we get:

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 Capital Accumulation, Structural Change and Real Exchange Rate in a Keynesian-Structuralist Growth Model 249

( )
= ( ) , . (26)

It can be easily shown that > 0, that is an increase in the level of real ex-
change rate (a devaluation of real exchange rate) will increase the growth rate of out-
put that is compatible with the balance of payments equilibrium in the long-run.
The relation between balance of payments equilibrium growth rate and real
exchange rate [BP curve] is shown in Figure 2.

Source: Authors own elaboration.

Figure 2 Balance of Payments Equilibrium Growth Rate as a Function of Real Exchange Rate

5. A Keynesian-Structuralist Growth Model and Exchange Rate

Policy
We will now combine the models developed in Sections 2 and 4 in a single Keyne-
sian-Structuralist growth model. The model has two fundamental equations. The first
one - Equation (12) - regards to the short-run equilibrium condition in goods market.
This equation defines the growth rate of capital stock that is required for the equality
between the growth rate of aggregate demand and growth rate of capital stock in or-
der to produce a constant level of capacity utilization. The second one - Equation
(22) - regards to the long-run equilibrium in the balance of payments. This equation
defines the growth rate of real output that is compatible with balance of payments
equilibrium.
In steady-state, output and capital stock must be growing at the same rate. This
means that:
= . (27)

And, in consequence, we get:

= , (16)

( )
= ( ) , . (26)

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250 Jos Luis Oreiro, Fabricio Missio and Frederico G. Jayme Jr.

Since the relation between capacity growth and real exchange rate is hump-
shaped [IS curve], we will have two long-run equilibrium positions for the economy
as we can see in Figure 3 below:

BP

IS

Source: Authors own elaboration.

Figure 3 Long-Run Equilibrium Values for Growth Rate and Real Exchange Rate

In Figure 3 is long-run equilibrium level of real exchange rate that corres-

ponds to an over-valued currency - that is, a level of real exchange rate that is lower
than the optimal level [ ] - and is the long-run equilibrium level of real exchange
rate that corresponds to an under-valued currency - that is, a level of real exchange
rate that is higher than the optimal level of real exchange rate. As we can easily see
in Figure 3 an equilibrium with under-valued real exchange rate is associated with a
higher growth rate of real output compared to an equilibrium with over-valued real
exchange rate. Under-valuation of real exchange rate is good for long-term growth.
As we have done in Section 2, we will now run a numerical simulation of the
model. In order to do so, let us assume that income elasticities of exports and imports
are given by:
( )= + , (24a)

( )= . (25a)

Table 2 shows the numerical values for the remaining parameters of the mod-
el:

Table 2 Numerical Values for the Parameters of Balance of Payments Equilibrium Growth Model
Parameter Numerical value
1
0,15
1,2
-0,01
, 0.04
Source: Authors own elaboration.

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 Capital Accumulation, Structural Change and Real Exchange Rate in a Keynesian-Structuralist Growth Model 251

For the parameter values show in Tables 1 and 2, the long-run equilibrium po-
sitions of the economy can be visualized in Figure 4 below:

0.05
0.045
0.04
0.035
0.03
0.025
0.02
0.015
0.01
0.005
0
0.1 0.3 0.5 0.7 0.9 1.1 1.3 1.5 1.7 1.9 2.1 2.3 2.5

Growth rate of capital stock Balance of payments equilibrium

Source: Authors own elaboration.

Figure 4 Growth Rate of Capital Stock and Balance of Payments Equilibrium Growth Rate as a
Function of Real Exchange Rate

In order to analyse the stability of long-run equilibrium we will suppose that

the economy is always in short-run equilibrium, so that Equation (12) is continuously
fulfilled. This means that our economy is always on the IS curve on Figure 3.
However the same is not true for our BP curve. In the short-run, the economy
can run current account surpluses or deficits, the last ones being financed by loss of
international reserves.
We will suppose that exchange rate regime is a crawling peg, in which mone-
tary authorities set the rate of change of nominal exchange rate according to the fol-
lowing equation:
= + . (28)

Where: is the desired rate of change of real exchange rate by monetary au-
thorities.
The desired rate of change of real exchange rate is, for now, supposed to be a
function of the difference between the long-run growth rate of exports and imports as
we can see in Equation (24):
= ( ) ( ) , ; < 0. (29)

Equation (24) states that monetary authorities desire to increase (decrease) real
exchange rate when imports are growing at a faster (lower) rate than exports. In other
words, monetary authorities are just reacting to balance of payments disequilibrium
by means of adjusting the level of real exchange rate; as a matter of fact they are just
copying the behavior of exchange rate in a floating exchange rate regime. Under this

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252 Jos Luis Oreiro, Fabricio Missio and Frederico G. Jayme Jr.

quasi-market rule, a devaluation of real exchange rate will be executed by mone-

tary authorities when:
( )
>0 < . (30)
( )

In other words, real exchange rate will be devalued when the growth rate of
real output is lower than the balance of payments equilibrium growth rate; otherwise,
real exchange rate will be appreciated.
With this dynamics for real exchange rate it can be easily demonstrated that
the equilibrium with over-valued exchange rate is dynamic stable, and the equili-
brium with under-valued exchange rate is dynamic unstable. This means that for le-
vels of real exchange rate in the interval (0, ), this economy shows a long-run ten-
dency for exchange rate over-valuations, what seems to be a fundamental feature of
medium-income economies (see Bresser-Pereira 2010). As a consequence of this
tendency for over-valuation of real exchange rate, this economy will also have a low-
er growth rate than the one it could get with the same parameters or fundamentals.
This result, however, can be reversed if monetary authorities, instead of trying
to replicate market behavior, set exchange rate policy in order to target some de-
sired level for real exchange rate. In this case, the target could be precisely the level
of real exchange rate in the under-valued long-run equilibrium. This means replacing
Equation (29) by:
= ( ); < 0. (29a)

It is clear that under this exchange rate rule, the equilibrium with under-valued
currency is now stable and the equilibrium with over-valued currency is unstable.
This result shows that the exchange rate policy that is adequate for a robust economic
growth in the long-run is to target real exchange rate at a competitive level, as sug-
gested by Roberto Frenkel (2002).
Regarding the inflationary consequences of this exchange rate rule, we know
from Equation (12) that a devaluation of real exchange rate is followed, due to real
wage resistance, by a permanent increase in the level of inflation. This may be prob-
lematic for policy authorities mainly in countries where there is a formal or informal
commitment to a certain level of inflation, in other words, in countries that had an
explicit or implicit inflation targeting regime. This means that the implementation of
such exchange rate rule demands the adoption of some kind of income policies,
where a short-term decrease in real wages is negotiated with workers in trade for a
higher level of employment and wage rate growth in the medium and long term. As
shown by Bresser-Pereira, Oreiro, and Marconi (2015, Chapter 16) a short-term de-
crease in real wages may be of workers interest if it was followed by an increase in
the rate of capital accumulation and productivity growth. In this case, the once-and-
for all decrease in the level of real wages due to devaluation of real exchange rate
will be followed by a higher growth rate of real wages in the medium term. This
means that in a relatively short period of time (six or seven years) the level of real
wages will be higher than it would be if real exchange rate was not devalued.

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 Capital Accumulation, Structural Change and Real Exchange Rate in a Keynesian-Structuralist Growth Model 253

6. Final Remarks
The present article developed a Keynesian-Structuralist growth model in order to
analyse the long-run relationship between the level of real exchange rate and eco-
nomic growth. The model combined some important features of the post Keynesian
growth and distribution models as, for instance, the relation between pricing deci-
sions, income distribution and capital accumulation; with some features of Latin
American Structuralism like the emphasis on the relation between productive struc-
ture, external constraint and economic growth. Both theoretical traditions could be
combined in the same growth model by one linking element: the idea that a faster
economic growth requires structural change that can only be realized by means of a
faster pace for capital accumulation. In this setting the level of real exchange rate can
induce both a higher rate of capital accumulation and a change in the productive
structure of the economy by means of increasing the number of goods that are pro-
duce inside domestic borders.
For plausible parameters values, it was show that the model had two long-run
equilibrium positions, one with an over-valued currency and a low rate of economic
growth; and another with an under-valued currency and a high rate of economic
growth. If exchange rate policy is designed in such way that real exchange rate just
reacts to balance of payments disequilibrium, than the over-valued equilibrium will
be stable and the economy will show a long-run tendency for over-valuation of real
exchange rate. However if exchange rate policy had a clear target for real exchange
rate, than under-valued equilibrium will be stable and the economy will show a high
rate of capital accumulation and economic growth. This means that the best contribu-
tion that macroeconomic policy can do for economic growth is to deliver a stable and
competitive level for real exchange rate.

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254 Jos Luis Oreiro, Fabricio Missio and Frederico G. Jayme Jr.

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